ESG: potential liability and litigation risk for banks

Linklaters recently published its Banking Litigation 2022: A look ahead, in which ESG is identified as one of the key areas that may give rise to potential liability and litigation risk for banks in the UK (and elsewhere). 

Environmental, Social, Governance

There is a growing consensus that climate change and sustainable development are this century’s major challenges. Increased scrutiny by key stakeholders such as regulators and institutional investors, as well as retail customers and activists, has prompted banks to give ESG factors greater prominence in their business strategy. The UK government published its ‘Roadmap’ to sustainable investing in October 2021 – following developments in Europe, the UK is considering its own taxonomy regime that will set clear expectations in relation to what constitute sustainable economic activities.

Below we discuss some of the key areas where these dynamics may give rise to potential liability and litigation risk.

Liability for inaccurate or misleading ESG disclosures

In the UK, as in other jurisdictions, the move towards mandatory climate reporting is continuing at pace. In relation to accounting periods beginning on or after 1 January 2021, premium listed companies are expected to include a statement in their annual report as to whether they have reported against the recommendations of the Task Force on Climate-related Financial Disclosures (the “TCFD”) (or to explain why they have not done so). More UK registered companies and financial institutions will be required to publish certain climate information for accounting periods beginning on or after 1 January 2022.

Additionally, on 17 December 2021 the FCA finalised its climate-related financial disclosure rules for asset managers, life-insurers, FCA-regulated pension providers and issuers of standard listed equity shares, with a phased approach to implementation starting from January 2022.

The UK Government has also announced that it intends to build on these requirements and will introduce a broader sustainability reporting regime in due course. In its Roadmap, the UK Government outlined its intention to introduce a new economy-wide Sustainability Disclosure Requirements (“SDR”) and a UK Green Taxonomy, which it hopes to finalise by the end of 2022.

ESG disclosures in particular will pose real challenges until reporting capabilities mature. Certain qualitative information may be hard to verify and require the cooperation of third parties, while the introduction of formal metrics and quantitative data analysis increases the likelihood of disclosures being technically inaccurate at the granular level. Inconsistent methodology and understanding of key terminology across sectors and institutions may impede proper understanding of disclosures and prompt allegations that disclosures are misleading.

Aside from the reputational damage that inaccurate or misleading disclosures can cause, and the regulatory attention they are likely to receive, there is a range of possible criminal and/or civil liabilities that may apply in relation to disclosure failures. Failures to disclose where there is an obligation to do so entail their own legal risks and more broadly there are market and regulatory expectations that businesses will be open with stakeholders in relation to ESG issues.

While claimants face challenges in bringing claims for inaccurate ESG reporting in the UK, in particular where it is necessary to establish reliance and/or recklessness or fraud, law firms looking for clients for class actions will have ESG issues firmly in mind.

The growing risk of greenwashing claims for financial products

The labelling of ‘green’ or ‘sustainable’ disclosures is becoming increasingly prevalent in other contexts, including statements made in product offering documentation and marketing materials used for asset management, private wealth clients and retail investors. This gives rise to the risk of ‘greenwashing’ claims, where such disclosures are found to be misleading.

In November 2021, the Financial Conduct Authority published a discussion paper proposing a product classification, labelling and disclosure regime as part of the new SDR regime. As financial services providers grapple with the issues concerning reliable ESG data (discussed above), issuers and those providing asset management and wealth management services will need to be very mindful of the statements used in various marketing materials. They should also be alive to the fact that products they have previously classified as ‘green’ or ‘sustainable’ may not align with the taxonomy as expected, and so there may be a need for careful further disclosure and explanation to clients in this regard.

Increased scrutiny of corporate lending activities and other services

A growing number of financial institutions are publicly committing to net zero financed emissions by 2050 to support the goals of the Paris Agreement and during COP26 the UK Chancellor announced plans to publish in 2022 a pathway for the financial sector’s transition to net zero. Over time this will influence decisions on whether and how to finance different types of business. Financing of high carbon-emitting companies, particularly those who are not yet decarbonising their own operations, is attracting attention from certain stakeholders and activist groups. Indeed, outside the UK, formal complaints have been brought against banks under OECD soft law standards, alleging failures by banks to adhere to policies concerning the environment.

It remains to be seen whether banks in the UK will become a new litigation target in the growing trend, particularly visible in Europe, of claims against carbon intensive businesses and against states for failures to take sufficient steps to align with Paris Agreement ambitions. Banks will need to take the broader litigation risk landscape into account when assessing the bankability of new projects they finance, and in relation to existing financings particularly with regard to projects which are perceived by certain stakeholders to be controversial from a climate or broader ESG perspective. In the UK, legal challenges are increasingly being brought in relation to the grant of project-specific authorisations, causing project delays and uncertainties.

The concept of the ‘value chain’ is not just gaining traction in climate litigation. Banks are also coming under increased scrutiny in connection with the human rights performance of the companies and projects in which they are invested. Under widely recognised international soft law standards there is an expectation that banks will work with others through their business relationships to seek to address adverse human rights impact and the UN’s High Commissioner for Human Rights has clarified that this would apply even if the financial institution is only providing custodian or nominee shareholder services. A complaint has also been brought outside the UK under OECD soft law standards in relation to passive investment strategies and it is possible such claims will be replicated here.

Separately, claims continue to be brought in relation to diesel emissions scandals and those claims typically target not just the manufacturers but also the financing entities that provided credit to consumers for vehicle acquisitions. Financing companies will, therefore, continue to be brought into the proceedings going forward.

Managing ESG risk across space and time

We have commented above on the UK position. However, other regions, in particular, the US and Europe, are forging their own approaches to the management of ESG risks. Early details in the UK ‘Roadmap’ suggest that the structure of the UK taxonomy will largely mirror that of the EU taxonomy, although as both taxonomies continue to evolve it remains unclear to what extent they will align. Therefore, while there is likely to be some overlap, it would be wrong to assume that a “one-size-fits-all” approach will be sufficient, leading to challenges in terms of efficient but comprehensive compliance frameworks.

Further, while much attention is focused on the future and what it brings in terms of ESG obligations, past conduct is not immune from scrutiny and legal risk.

For a discussion of other themes likely to shape the legal risks faced by banks and financial institutions this year, see the Linklaters Banking Litigation 2022: A look ahead.